HKUST Business Review

36 HKUST Business Review Insight 3 Proposed Regulatory Approaches May Backfire In other words, SPACs result in both losses for regular investors and less-efficient allocation of capital, such that less-profitable projects may get funded and more-profitable projects may not. Moreover, many attempts to address these issues through regulation may come with substantial unintended consequences. More disclosure requirements increase information asymmetry. One of the most common ways in which regulators tend to try to address market distortions is by increasing disclosure requirements. In theory, if investors have more access to information, they should act more rationally. Unfortunately, in the case of SPACs, this may not be the case. Instead, providing more technical data can actually widen the gap between sophisticated and unsophisticated investors. This is because sophisticated players will use the new data to refine their advantage, while overconfident investors may become even more overconfident, believing that they understand more without actually changing their behavior (since highly technical data can be highly inaccessible to regular investors). In other words, unsophisticated investors experience the downside of more information asymmetry instead of the upside of improved decision-making. Restricting access shrinks the SPAC market without addressing its core problems. Another common lever that regulators can pull is restricting access to the SPAC market. Banning retail investors from SPACs would likely improve returns for any who remained, as they would face less competition from an overconfident crowd driving up prices. However, this would also reduce profits for sophisticated investors and shrink the entire SPAC market, potentially closing off a viable (if flawed) path to public markets for some companies. Eliminating key features of SPACs also eliminates their upside. Similarly, some regulators have proposed eliminating the warrants or redemption rights that make SPACs unique. Removing warrants would remove some of the advantages of this market and make shares less attractive, thereby reducing the potential for overpricing. This would directly benefit buy-and-hold investors, but it would also make it harder for sponsors to fund their ventures. Along the same lines, eliminating redemption rights would turn SPACs into traditional blind-pool investments, forcing all investors to commit their capital for the long term. This would also remove the very feature that overconfident investors overvalue, again shrinking the market. A Better Way to Tackle the Overconfidence Problem: The SPAC Nutrition Label My research suggests that a core problem with SPACs is the overconfidence of unsophisticated investors. As such, disclosure requirements mandating hundreds of pages of technical jargon, or market controls that eliminate the very features that make SPACs unique, may not be the best approach. Instead, a simple, one-page “SPAC Nutrition Label” at the front of every prospectus could help address information asymmetries and reduce investor overconfidence without eliminating SPACs’ potential to fill an important market gap. Like the summary of nutrition facts displayed on food packages, a SPAC Nutrition Label would state, in plain language: • The percentage of shares held by the sponsor • The total number of warrants outstanding • The amount of cash per share remaining after estimated redemptions • A clear, historical comparison of average SPAC returns versus the S&P 500 This would not prohibit regular investors from investing in SPACs, but it would empower them to make more informed choices when they do so. It would make the true risks more salient, helping to bridge the gap between the perceived and actual value of a SPAC share. As a result, investors would act less overconfidently, ultimately ensuring that capital is allocated toward more-profitable projects and that sponsors and sophisticated investors are not benefiting at the cost of retail investors. Since their boom in 2021, the SPAC market has shrunken substantially, and the relative attractiveness of the SPAC structure has fallen compared to a traditional IPO. That said, in 2024, SPACs still raised nearly US$10 billion. While SPACs are less popular than they were a few years ago, they are still an important component of the financial ecosystem. As such, it’s critical for regulators to take a clear-eyed approach to capturing their potential while minimizing the risks they pose to regular investors and the economy at large. 1 2 Martin Szydlowski is an associate professor of economics at HKUST, focusing on game theory, industrial organization, and finance. This article draws on the research paper “Harnessing the Overconfidence of the Crowd: A Theory of SPACs,” authored by Snehal BANERJEE and Martin SZYDLOWSKI.